Accounting for leases Essay

Abstract
This paper will provide an overview of lease accounting. It will present the history, current status, and future implications of the latest proposed standard, as jointly issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). Furthermore, the paper will take into account relevant observations made by various proponents who are concerned about the standard, and conclude with a personal opinion on the standard and why it’s better than the current standard.

Existing accounting standards between the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have allowed corporations to avoid reporting assets and liabilities via “operating leases.” Thus, it has become common practice for corporations to utilize these operating leases as a source of deceptive financing—by being able to materially mislead creditors and investors due to off balance sheet accounting. Lease accounting is a classic example (or phenomenon) that shows how people tend to exploit accounting standards in order to violate the “substance over form” accounting principle (where the economic reality can be distorted from the legal reality).

The history of lease accounting is an interesting one. In 1976, FASB released Statement of Financial Accounting Standards (SFAS) No. 13 – Accounting for leases. Since then, the accounting standard allowed companies to report some leases as an asset and a liability (i.e. capital/finance leases), and other leases as a non-asset and non-liability (i.e. operating leases). However, since the FASB-IASB convergence project began (from the 2002 Norwalk Agreement), they have reached a general consensus with investors that in many instances, operating leases can be misleading and could cover up material amounts of credit risk of a given company.

It is interesting to note that such an issue had already been acknowledged by the late 70s, shortly after FASB released SFAS 13 (Kieso, Warfield, & Weygandt, 2004, p.1119). The issue was momentarily brought up again during the early 90’s for resolution, but was sharply protested by corporate interests and subsequently dismissed (Norris, 2013). Only now, has there been serious reconsideration of the standard; and can demonstrate how long it can take for accounting standards to respond back to the needs of financial statement users.

On June 16, 2005, the US Securities and Exchange Commission (SEC), in response to the Sarbanes-Oxley Act (SOX) of 2002, publically released “On Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers.” This public statement proposed several important goals and recommendations, among them a proposal to improve accounting for leases. By July 2006, the FASB and IASB established a Work Plan, in order to improve the standard for lease accounting (“Work Plan for IFRS – Leases,” 2013). The project has yet to be completed. Details about its current status will be described next.

On May 16, 2013, FASB-IASB has released their latest exposure draft on accounting for leases. Based on user feedback, this draft arose from earlier draft iterations that were released in March 2009 and August 2010 (“Exposure Draft,” 2013, p. 1). If approved, the draft would supersede IFRS IAS 17 and FASB Topic 840 (“Exposure Draft,” 2013, p. 2). As a result of this draft, FASB-IASB will also attempt to concurrently update revenue recognition standards accordingly, as the latest proposal intends to make sure the accounting for revenues and expenses for both the lessor and lessee will be consistent with each other (“Exposure Draft,” 2013, p. 1). Furthermore, there are still some minor differences that exist between the FASB and IASB drafts, among them being: revaluations, cash flow, disclosure, non-public entities, and measurement issues (“Exposure Draft,” 2013, pp. 4-5). The feedback deadline for this draft is September 13, 2013 (“Exposure Draft,” 2013).

As it turns out, this draft decided to take a much more prudent approach (compared to earlier proposals) towards lease accounting, allowing standards similar to SFAS 13 to remain applicable in practice for any leases that have terms of 12 months or less… or if it is a “Type B” lease (which will all be further explained below) (“Exposure Draft,” 2013, p. 3). In effect, this would allow lessors to continue to structure their lease terms accordingly, which allows lessees the ability to renew these short-term leases in order to continue to practice off balance sheet financing.

So what’s the current proposal to account for lease terms that are more than 12 months? First, the exposure draft would require entities that enter such a leasing contract to recognize the “right of use” asset and its associated liability (“Exposure Draft,” 2013, p. 2). Second, the draft requires the entities to recognize the underlying “nature” of the asset as being either: Type A (non-property) or Type B (property) (“Exposure Draft,” 2013, p. 2). Third, the draft requires the lessee to assess how much economic benefit it reasonably expects to derive from the “right of use” asset (“Exposure Draft,” 2013, p. 2). Furthermore, the draft has guidelines for both the lessee and the lessor. These accounting guidelines will be described next—first for the lessee, then for the lessor.

For the lessee, if the lease is Type A, the lessee is required to recognize the associated Leased Asset and Lease Obligation on the Balance Sheet (“Exposure Draft,” 2013, p. 2). The asset could be depreciated, and the respective portions of the Lease Obligation are to be listed under the Liability and Debt sections of the balance sheet, respectively. The asset and associated liability is to be initially measured by using the “present value” method (where the initial account balances reflects the present value of the future amount) in order to account properly for Interest Expense payments made during the whole course of the Lease Obligation (“Exposure Draft,” 2013, p. 2). The lessor is required to de-recognize the Leased Asset from the Balance Sheet. In its place, the lessor must recognize the Lease Receivable and Residual Asset (“Exposure Draft,” 2013, p. 3). The assets are also initially measured using the same present value method, in order to account properly for the interest earned apart from the Lease Revenue throughout the whole term of the lease (“Exposure Draft,” 2013, p. 3).

If the lease is Type B, the exposure draft proposes that both the lessee and the lessor should account for the lease as an operating lease if the lessee is NOT “expected to consume more than an insignificant portion of the economic benefits embedded in the underlying asset” (“Exposure Draft,” 2013, p. 3). Thus, the lessor would continue to recognize the underlying asset, while the lessee simply account for the annual lease expense (“Exposure Draft,” 2013, p. 3). Again, this accounting treatment is the same for any leases that have terms of 12 months or less.

Keep in mind however, that if the lessee were to consume a significant portion of the economic benefits under a Type B lease, the accounting treatment for both the lessee and lessor would be similar to a Type A lease (“Exposure Draft,” 2013, p. 2). In this case, the lessee would be required to recognize an asset and liability from the property lease. I believe such proposal was intended, as it allows companies to gradually adjust to the new treatment standards, whereby future amendments could someday require all short-term leases (and Type B leases) to be capitalized to better reflect the economic reality of “short-term” lessees.

So, what do the proponents of the exposure draft think of the new standard and its impact on the future? As expected, there are some who agree with the draft and others who think otherwise. Dhaliwal, Lee, and Neamtiu (2011) did a quantitative and qualitative empirical study—of which evidence suggests “that lessees bear insufficient risk to treat the leasehold as an asset” (p. 193). This implies that the new proposal would not significantly increase the cost of capital for any firms that would have to start capitalizing their operational leases. Cotton, McCarthy, and Schneider (2012) found that most firms under current lease accounting are able to combine associated obligations from their capitalized leases with other obligations (p. 118).

This would not be allowed under the new proposal, thus improving transparency and quality of information to investors. Middelberg and Villiers (2013) did a similar study, of 40 JSE-listed (South Africa) companies. Interestingly, their findings within this study suggest that the cost of financing would increase for firms that would have to capitalize operating leases. Their findings suggest that companies should expect to experience the following changes to their financial ratios: Debt-to-equity to increase by 9%, Debt ratio to increase by 8%, and the Interest cover ratio to decrease by 8% (Middelberg & Villiers, 2013, p. 663). This implies that the new proposal would cause investors to see such companies as higher investment risks, thus increasing borrowing costs. Burton (2013) doesn’t believe in the new proposal, instead suggesting that the current standards be amended to address the areas that are vulnerable to exploitation.

He thinks the FASB should consider revising the four criteria provided in SFAS 13 that determines if a lease should be capitalized. In particular, he encourages the FASB to change the 90% present value rule—which currently impose no such requirements for lessors to reveal the actual discount rate to the lessee. As a result, lessors are able to keep the leased asset on their books as a capital lease by using a low discount rate, while the lessee can use a higher, in-house discount rate in order to avoid the need for capitalizing the lease. Quah (2013) reasoned that the proposed changes could have a more significant effect on retailers, as they are known to have major property leases. In particular, she notes that as the liabilities increase from capitalizing such leases, it would have negative effects on debt, employee compensation, and tax balances.

This could cause major implications, as retailers (department stores, discount chains, convenience stores) are key economic players in the economy. Similarly, it would effect other major industries—such as real-estate, major airlines, and shipping firms. Norris (2013) made a point that the new proposal could cause some revenue (income statement) challenges, as the present valuation methods would cause lessees to incur higher interest payments during the earlier years of the leased assets. This could especially be disappointing for early business startups (that typically need to take out more loans) and for any firms needing to maintain a lower cost of capital (that they would have otherwise been able to receive under operational lease accounting). Taken all together, the aforementioned observations basically imply that the future impact of the new proposal on lease accounting would effect all the major players within the economy, especially the retail, real-estate, and transportation industries.

Furthermore, there is likelihood that higher borrowing costs would result for some of these businesses, forcing them to possibly reduce employee benefits and/or compensation in order to better align their financials to changing budget forecasts. On the other hand, investors will have access to higher quality, transparent information—reducing uncertainty and risk to maintain lower interest rates. And as I mentioned earlier, the proposal still gives lessors and lessees the opportunity to restructure their lease terms for annual renewal, avoiding the need to capitalize such leases and to keep them “off the books.” But by doing so, it would imply higher legal costs for some of these lessors and lessees, and thus, act as a deterrent in support of the new standard for capitalizing leases. I feel the FASB-IASB is wise to have taken a more balanced approach for changing the requirements of lease accounting.

By doing so, it allows the majority of companies to readjust their accounting policies to better reflect economic reality (instead of legal reality). Also, the more transparent and specific requirements stated in the proposal for reporting liabilities and debt in the financial statements will have a long-run, positive impact—as it ultimately helps reduce uncertainty between investors and management. I feel these benefits will outweigh the costs (including the transitional-related costs that entities would have to pay in order to update their accounting policies and methods). Besides, these new accounting costs will be reduced over time anyway, as firms become accustomed to the new standard. In summary, by forcing companies to report more honestly to investors, it induces management to better utilize their resources in order to maintain healthy margins, instead of resorting to fraudulent activities.

Thus, I believe that the standard is a win-win for both internal and external parties, as it better forces them to manage their resources more responsibly, and prevents management from supporting an exploitative culture that had been taking place during the past 25+ years with the old standard.